Microsoft: Decent Buying Opportunity

Summary:

• Microsoft’s share price has surged significantly over the past few months.
• I go over the company’s financials and upcoming plans for the future, specifically for AI, gaming and cloud technology.
• Using a simple EPS projection, and considering other analyst estimates, I assign a ‘Buy’ rating on Microsoft stock, at a price target of $425.21.

Since the start of the year, the share price of Microsoft (NASDAQ:MSFT) has experienced a sustained increase, from about $370 to $425 – a near 15% run in just 4 months. In the same year, the company eclipsed Apple (NASDAQ:AAPL) as the most valuable company in the world by market capitalisation. Being one of the blue chips in the Magnificent Seven, Microsoft stock has found its way in many retail and institutional investors’ portfolios. However, the recent surge in stock price has left value investors second-guessing if the stock is still at fair value. In this article, I go over Microsoft’s impressive run over the years, and what they have in store for the future. Using a simple EPS projection, I explain why Microsoft stock is still currently at its fair value.

A Promising Trajectory

It’s no secret that Microsoft has made a global name for itself. The company’s growth in the past few years have been nothing short of impressive, and its future trajectory remains bright.

Revenue growth

The company wrapped up 2023 with a whopping $211.92b in revenue, almost double of what the company did in 2019 ($125.5b). This is a 14% compound annual growth rate from 2019 to 2023. If we zoom out further, we see that the company’s revenue has been on a sustained trend of growth despite weathering various economic crises and multiple changes in the technological landscape.

While this is no surprise to most, it’s the composition of revenue that gives me confidence in the company.

We often know the company for its renowned operating system Windows, and the various applications that come along with it. Others know the company for search engines, devices or networking platforms like LinkedIn. However, we see from above that the biggest share of the revenue pie comes from server products and cloud services – these contributed to over a third of Microsoft’s revenue in 2022. Now, why is this significant?

We see that the U.S. cloud computing market is on an upward trajectory. Indeed, the cloud is becoming the new norm for servers, networks and data storage. A shift in focus to such products is an indication that the company adapts to technological trends, and we see that Microsoft Azure definitely holds its own in the cloud computing space.

We observe that as of Q3 2024, Microsoft Azure has 24% market share for cloud infrastructure, largely exceeding big names like Google Cloud and Alibaba Cloud and only lagging behind Amazon Web Services. This is a good representation of Microsoft’s dominance in the market, and we can expect the company’s revenue from such services to continue its upward trajectory. As such, we see that the company not only boasts increasing revenue over the past two decades, but a constant pivot towards what’s revolutionary and profitable in the technological space.

Leverage and solvency

Apart from being a revenue-generating machine, Microsoft’s financials also indicate that the company is solvent and thus, more than able to meet its long-term debt obligations. As of 2023, let’s go over the company’s main solvency and leverage ratios.

The company’s debt-to-asset ratio stands at about 0.18 – an impressive metric indicating that the company’s total assets are about 5.6 times its total debt. The company’s debt-to-equity ratio is also impressive. Standing at about 0.35, the company’s total equity is almost thrice its total debt! One thing to note, however, is that Microsoft’s free cash flow-to-long term debt (FCF to LTD) ratio pales in comparison, with its free cash flow actually being lesser than its long-term debt. Indeed, with the company’s recent investments in artificial intelligence – famously a $10b investment into OpenAI in 2023 – a decline in free cash flow is expected. Nonetheless, the company as a whole proves to be more than able to meet its obligations – an important consideration when evaluating a company’s financials.

Overall profitability

We now go over the recent trends in profitability metrics to show that Microsoft has been consistently profitable over the years. Firstly, in the year 2023, the company reported a gross profit margin of 68.92%. In other words, about 69 cents is retained as profit for every dollar earned in revenue. This is impressive considering Microsoft was triumphant over industry competitors Amazon.com Inc (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG), whose margins were 46.98% and 56.75% respectively in the same fiscal year. Let’s now zoom out and observe the company’s net income over the past two decades.

Much like its revenue, the company’s net income has been on an upward trend, notably surging after 2018 with rapidly increasing adoption of cloud technology. With the company consistently buying back shares (7.75b shares in 2019 compared to 7.47b shares in 2023, a compound annual decline of about 1%), this has also led to a sustained increase in the company’s earnings-per-share (EPS) – which went from $5.06 in 2019 to $9.68 in 2023, a compound annual growth rate of 17.6%. A company’s EPS ultimately measures how much the company earns per share of its stock – a metric most investors of Microsoft stock would care about, so this is definitely a promising trend. All in all, Microsoft’s profitability metrics are all pointing in the right direction.

The Future Ahead

Now that we’ve gone over the company’s financials, let’s see what we can expect from Microsoft in the coming years.

Heavy investments into AI

Microsoft has always been in the AI scene, famously investing $13b in total into OpenAI. The company’s first investment into the AI startup was as early as 2019 – before ChatGPT was even invented! Leveraging on OpenAI’s cutting edge solutions in artificial intelligence, Microsoft Copilot was born in 2023. The feature integrates the technology behind the famed ChatGPT to optimise the user experience on Microsoft 365 applications. With the same technology, Copilot also provides solutions to businesses and individuals by enhancing productivity and streamlining traditional processes.

We see from the simple illustration above that the new introduction by Microsoft surely holds its own in terms of utility. In addition to the basic features of content generation, integration with data security and Microsoft 365 is also included. Apart from Copilot, we also see that Microsoft is investing in various AI startups – with Figure and Mistral AI being the more recent ones. While we’ve yet to see the full extent of these investments, this definitely shows Microsoft’s commitment to keeping up with current technological trends and cementing itself as one of the main leaders in AI-integrated solutions.

Gaming acquisitions

Apart from ventures into AI, Microsoft has also recently completed its acquisition of Activision Blizzard, a popular video gaming company known for publishing some of the most played games in the world like World of Warcraft, Candy Crush and Call of Duty. The acquisition deal was a whopping $68.7b – Microsoft’s largest acquisition to date. Such a move would further support the company’s gaming arm, powered by the well-known Xbox. We’ve seen earlier in the article that just 8% of Microsoft’s revenue comes from its gaming business – a number that could see a rise considering Activision Blizzard’s huge player base and dominance in the eSports scene.

The chart above shows Activision Blizzard claiming over 21% of the eSports market share in 2021, eclipsing the likes of Nintendo and Tencent by a considerable margin. With this new massive acquisition, we could see a rise in overall revenues due to growth in the company’s gaming business.

Rapid cloud growth

As seen earlier, 34% of Microsoft’s revenue was earned from server products and cloud services, and we can expect this growth to accelerate given the trajectory the cloud computing industry is on.

We see from above that even though Microsoft Azure lags behind Amazon Web Services in global market share, it experienced the highest year-over-year growth in cloud revenue. This is significant, especially after considering that the company had outdone its previous quarter which boasted an impressive 26% year-over-year growth in cloud revenue. In addition, it was reported earlier this year that Microsoft Azure’s OpenAI services will be integrated into the cloud’s government platform, Azure Government, to discover new solutions in crafting policies and analysing data with generative artificial intelligence. Rapid adoption of Azure, along with AI integration, could definitely bring Microsoft to heights we’ve never seen before.

Valuation

Now, we use a simple 5-year projection of the company’s earnings-per-share, and discount it by its weighted average cost of capital to obtain an estimate of the fair valuation of Microsoft stock.

Assumption

We will use Microsoft’s current trailing-twelve-month EPS of $11.10 and the company’s weighted average cost of capital of 8.79%. As for annualized earnings growth, I’ve decided to go with a fair projection of 15% – a couple of percentage points lower than what the company has done on average from 2019 to 2023. Given the company’s history of buying back shares, I also do believe that projecting an annualized 1% share buyback is fair. For the company’s projected P/E, I’ve gone for 30, a little above the company’s 10-year average P/E of 29.4 and significantly lower than the company’s current P/E of 38.6. Finally, I’ve slapped on additional 8% margin of safety.

Intrinsic value

Based on my relatively conservative assumptions, we have arrived at a fair value of $425.21 per share for Microsoft stock. This isn’t too far from where the stock is trading at right now!

Analyst ratings

A quick look at this year’s coverage of Microsoft stock shows that the price targets are well above the current stock price – Morgan Stanley being the most optimistic with a price target of $520. The average price target for Microsoft stock based on 2024’s ratings stands at about $494 a share.

Final investment decision

All in all, it’s hard to deny that Microsoft is a company that has a well-proven track record, and also a bright future ahead. With its investments in gaming, cloud technology and artificial intelligence, the company stands to remain profitable even in the ever-evolving technological landscape. As for the company’s stock valuation, the assumptions in my EPS model are relatively conservative, and other analysts from larger institutions definitely have more bullish projections. In my opinion, the company is fairly investable at its current valuation, as there is a more than reasonable chance that Microsoft matches or outperforms my projections if it stays on its journey of growth and innovation. As such, I rate Microsoft Stock a ‘Buy’, at a price target of $425.21.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in MSFT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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